This blog covers financial, political and other topics the author gets the urge to write about. It does not provide personal financial, legal or other advice. Consider consulting a personal professional adviser before making any decisions. Copyright (c) 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017 by Leonard W. Wang. All rights reserved.

Tuesday, July 30, 2013

From the Fed: Short Term Gain, Long Term Pain

As the Fed's ultra low interest rate policies grind on for a fifth year, we can see ever more clearly that there is no such thing as a free lunch, even when it comes to central bank policies. The benefits of the Fed's low interest rate policies were easy to see at first: cheap credit, stimulus to housing, a boost to the economy. The costs didn't seem so great.

However, by persistently favoring borrowers and heaping mulch on income-seeking investors for five years, the long term costs of the Fed's policies are emerging--and painfully so. Detroit is in bankruptcy, and other cities teeter on the brink. Corporate defined benefit pension plans are becoming less common than the ivory-billed woodpecker. It's no wonder why. Pension funds rely on safe long term investments that provide solid returns. U.S. Treasury notes and bonds used to be crucially important components of pension fund portfolios. AAA-rated corporates, which would have to pay slightly better than Treasuries, also were favored investments. But pension plan returns came under stress as the returns on these low-risk investments nosedived. And pension fund deficiencies, calculated on the basis of long term returns, balloon when returns fall. Plan sponsors have to increase contributions--sometimes enormously--to keep the plans solvent. Corporate executives intent on making the big score with their stock options see little upside to signing off on these contributions. Shrinking cities like Detroit have little ability to make them. Something has to give, and pensioners seem to be doing a lot of giving these days. Detroit's problems go well beyond low long term interest rates. But the city really didn't need the Fed to push it closer to the abyss.

Neither did a lot of corporate employees whose retirements are less secure after losing their defined benefit pensions or seeing the plans capped. Most people aren't skilled at managing their finances. When fewer have defined benefit pensions, more are likely to end up with just Social Security, even if they start retirement with good-sized 401(k) account balances. When people have fewer or no private resources, cutting benefits from the government becomes political anathema.

Low interest rates hurt older folks in other ways. As income from their interest-bearing investments dries up, fear drives them to become serial economizers. That's a hard habit to break even after rates rise again (assuming they do). Consumption may be impaired for a long time. In addition, long term care insurance is getting scarce and expensive. While poorly conceived estimates by insurers of the cost of care have much to do with that, the inability of insurers to obtain decent, safe returns on investments has added to the problem. Fewer people are able to afford such policies. So we have a ticking demographic time bomb, with lots of uninsured elderly likely to need Medicaid in a decade or two or three instead of being able to rely on their own resources. Low interest rates are beneficial to the federal government's borrowing costs right now, keeping the budget deficit lower. But positioning a lot of people to need Medicaid in decades to come means we'll have pressure toward an increased deficit in the long term.

The Fed is taking a page from corporate America: focus on short term returns at the risk of increasing long term costs. The great corporate success stories don't follow this plot line. But there's not much chance the narrative will change. The Fed's easy money merry-go-round keeps the stock market buoyant. With mid-term Congressional elections coming up next year, the Obama administration needs to keep the market feeling chipper. Ultimately, everything in Washington happens for political reasons. And politics dictates that Janet Yellen, a monetary dove, will be Obama's nominee as the next Chairman of the Fed.

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